Video Transcript: Dividend Discount Model

Hello, welcome. We're going to discuss the dividend discount model. What is the dividend discount model? The dividend discount model is a procedure for  valuing the price of a stock by using the predicted dividends and discounting  them back to the present value. If the value obtained from the dividend discount  model is higher than what the shares are currently trading at, then the stock is  under valued. So we'll work a quick example. So we want to find the value of the stock based on the dividends in the future. So we're going to find the value of  the stock and right now. So we'll use these dividends for this example, right? So  we'll use the $3 dividend for dividend one. So dividend one will be $3 dividend,  two, 315, dividend, three, 331, and 347,, now we're going to divide this by one  plus K. K is denoting, in this case, the required return. So in this example, we  use the CAPM calculation, .136, for our rate of return, .136, right? So this is for  period one, for period two. We'll do the same one plus .136, but because it's  period two, we need to raise it by the number of periods, one plus K, raised it by  the number of periods, three. Here, one plus K, 136, raised to the fourth. But  here we need to add in the sale price of our stock at the end of year four. So  let's say we bought it at 10 and we sell it at 1250 so we're going to add in 1250  so remind you we're trying to find the value of our stock the present value of this. So we are going to calculate this. Okay, so three divided by 1.136 is 2.64. So so  now we have 3.15 divided by one plus .136, and we'll raise that by two. So 2.44 so 3.31 divided by one plus .136, raise that to the third 2.25 so now we have  3.47 divided by one plus . 136, raised to the fourth. So and we'll add back in our 1250 sale price, 14.58 so this is at the end of year four, right? So we want to  know in the future, what is this stock price going to be? So we need to add 2.64  plus 2.44 plus 2.25, plus 14.58, give us 2191 price zero. 2191 is our current  stock price for this security according to the dividend discount model. Now we  can work through another example. Okay, so company, ABC, just paid a $3  dividend, and its dividend is expected to grow at a rate of 5% indefinitely, ABC  has a beta of .1 or 1.2 the return on the market is 12% the risk free rate is 4%  what would the intrinsic value of ABC stock be? Remember, we need to  calculate our required return using the CAPM model, but we first need to project  out the dividends. So we'll look here. So for dividend zero, our present dividend  is $3 but we want to know dividends one, two and three. So to find dividend one, the equation will be d zero plus one plus the growth rate. So here d zero is  three, because that's our current dividend times one plus the growth rate of 5%  so 1.05 times three is 3.15 this gives us dividend one. So for dividend zero for  time now present, our dividend is $3 next year, year one will be 315 for the next  period, we'll take d1 at 315 one plus the growth rate, this will equal 3.31 and  dividend three equals d2 One plus the growth rate. So d2 we bring down 3.31 1  plus .05, will give us $3.47 now we can estimate out our stock price in the future  based on these future dividend projections. So first we need to figure out the  discount rate by using the CAPM method. So remember CAPM return, risk free 

plus the market return minus the risk free rate times beta. So here you'll see that the risk free rate is .04, 4% plus .1, 2 minus .04, equals .136, okay. We need to  add in our beta 1.2 so we did 1.2 times .08 and multiply that by .04 to give  us ..136, or 13.6% now we are going to plug in our metrics into the constant  growth dividend Model, which looks like this constant growth dividend model. All  right, so we're going to go $3 for dividend, zero at one, plus the growth rate  divided by the required return or our CAPM percentage minus our growth rate,  and this is going to give us the stock price at period zero according to the  constant growth dividend model. Our current stock price for this scenario is  36.63 now we can project out the next period stock price by incorporating  dividend one value here, so we can do 3.15 times one plus the growth rate  divided by the required return minus the growth rate. So we can do this  calculation really quick. It's really easy this order of operations. So we will take  3.15 and multiply that out by 1.05 that's going to give us 3.3075 and we're going  to divide that by .13 minus .05 that gives us .086, so we will do 3.3075 divided  by .086, and it'll give us a stock price of $38.46 so you can still continue to  project out the stock price into the future. You could look at periods two and  three doing the same thing, just plug in the dividend value into that place, and  you can get these figures.